Analyzing and Managing Common Stocks Chapter 11 Charles P. Jones, Investments: Analysis and Management, Tenth Edition, John Wiley & Sons Prepared by G.D. Koppenhaver, Iowa State University

Impact of the Market Pervasive and dominant The single most important risk affecting the price movement of common stocks Particularly true for a diversified portfolio of stocks Accounts for 90% of the variability in a diversified portfolio’s return Investors buying foreign stocks face the same situation

Required Rate of Return Minimum expected rate of return needed to induce investment Given risk, a security must offer some minimum expected return to persuade purchase Required RoR = RF + Risk premium Investors expect the risk free rate as well as a risk premium to compensate for the additional risk assumed

Security Market Line Beta = 1.0 implies as risky as market kM kRF 1.0 2.0 0.5 1.5 SML BetaM E(R) Beta = 1.0 implies as risky as market Securities A and B are more risky than the market Beta >1.0 Security C is less risky than the market Beta <1.0

Understanding the Required Rate of Return Risk-free rate RF =Real RoR +Inflation premium Real rate of return is basic exchange rate in the economy Nominal RF must contain premium for expected inflation The risk premium Reflects all uncertainty in the asset

Passive Stock Strategies Natural outcome of a belief in efficient markets No active strategy should be able to beat the market on a risk adjusted basis Emphasis is on minimizing transaction costs and time spent in managing the portfolio Expected benefits from active trading or analysis less than the costs

Passive Stock Strategies Buy-and-hold strategy Belief that active management will incur transaction costs and involve inevitable mistakes Important initial selection needs to be made Functions to perform: reinvesting income and adjusting to changes in risk tolerance

Passive Stock Strategies Index funds Mutual funds designed to duplicate the performance of some market index No attempt made to forecast market movements and act accordingly No attempt to select under- or overvalued securities Low costs to operate, low turnover

Active Stock Strategies Assumes the investor possesses some advantage relative to other market participants Most investors favor this approach despite evidence about efficient markets Identification of individual stocks as offering superior return-risk tradeoff Selections part of a diversified portfolio

Active Stock Strategies Majority of investment advice geared to selection of stocks Value Line Investment Survey Security analyst’s job is to forecast stock returns Estimates provided by analysts expected change in earnings per share, expected return on equity, and industry outlook Recommendations: Buy, Hold, or Sell

Sector Rotation Similar to stock selection, involves shifting sector weights in the portfolio Benefit from sectors expected to perform relatively well and de-emphasize sectors expected to perform poorly Four broad sectors: Interest-sensitive stocks, consumer durable stocks, capital goods stocks, and defensive stocks

Market Timing Market timers attempt to earn excess returns by varying the percentage of portfolio assets in equity securities Increase portfolio beta when the market is expected to rise Success depends on the amount of brokerage commissions and taxes paid Can investors regularly time the market to provide positive risk-adjusted returns?

Efficient Markets and Active Strategies If EMH true: Active strategies are unlikely to be successful over time after all costs If markets efficient, prices reflect fair economic value EMH Proponents argue that little time should be devoted to security analysis Time spent on reducing taxes, costs and maintaining chosen portfolio risk

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